Taxing Times: Dividend Tax Changes in the UK Government's June 2015 Budget

Sorry this comes so hot on the heels of my analysis post regarding my recent Rolls-Royce purchase earlier today.

However, it's that time again. When people sit there trying to figure out whether they are better or worse off after the tinkering of governments. Oh joy.

This time round saw the first "pure blue" Conservative budget since 1996 (when I had not even reached a decade of life).

Needless to say--as a dividend investor--the thing that caught my eye was the changes to the tax relating to dividends.

Here I am going to have a go at understanding what has changed and how it may affect (an admittedly fictional) me and others with a couple of case studies. Such is the nature of tax policy with its various caveats, overlaps and more I am sure this remains somewhat incomplete. If so, please do add your comments below. I will adjust as I find out more!

For the financial independence fighters amongst you. I have an tax question in the final case study which--if you can--it would be great if you could answer!

Anyway, here we go.

The Way Things Are

At present the system revolves around the tax credit system. Each dividend payment you receive comes with a 10% tax credit attached. In other words, for all the dividend payments you receive you can pay 10% less of their value in tax.

What this means is that basic rate taxpayers find their dividends are effectively untaxed. For higher rate taxpayers their dividend tax liability drops to 25%. For additional rate taxpayers it is 30.56%.

Now this has been in place for about 40 years now (with lots of tinkering, of course, in between). Now, though, it has been changed.

The Way Things Are Going To Be (after April 2016)

Now George Osborne has decided to shake things up a little.

First, everyone will now get £5,000 of dividend income completely untaxed. 

Beyond that £5,000 dividend income all dividend will be taxed like this: Basic rate (7.5%), higher rate (32.5%) and additional rate (38.1%).

Put simply this is how the tax rates look when compared:

Dividend Tax Rate...	Tax-free Allowance	Taxpayers Bands
		Basic	Higher	Additional
Today (effectively)	£0	0%	25%	30.56%
From April 2016	£5,000	7.5%	32.5%	38.1%

According to the Treasury this means "that ordinary investors with smaller portfolios and modest dividend income will see no change in their tax liability--and some will pay less tax."

Certainly, it does look as though it hits higher taxpayers more than basic rate taxpayers.

Something to remember here, though, is that if your dividends are received within an ISA they remain completely tax free. 

What this does seem to do is make ISAs even more attractive investing vehicles as now even basic rate taxpayers get a very clear tax benefit (for dividend payments beyond the £5,000 threshold) of 7.5% over their non-ISA brethren.

A (Contrived) Case Study: Basic-rate Taxpayer

Let's take a quick case study. I am a basic rate taxpayer who has a portfolio which throws off £15,000 (lucky me) in dividend income which is not held in an ISA.

Before the changes I would pay--effectively--nothing in tax. But, what would I pay in tax next year?

Well, £5,000 is untaxed leaving £10,000 subject to the 7.5% tax. This means I would pay £750 in tax. In total, then my dividend income--net tax--would be £14,250. My effective taxrate (including the tax-free allowance) would be about 5%.

An (Even More) Contrived Case Study: Higher-rate Taxpayer

Let's say I am a higher rate taxpayer with £10,000 in dividend income outside an ISA. 

Under the current system I would pay £2,500 in tax on my dividend income leaving me with £7,500 in dividend income net tax.

But under the new system?

Again, £5,000 would be tax free leaving £5,000 taxed at 32.5%. This would mean the tax extracted would be £1,625. In total my tax liability would leave me with £8,375 in dividend income. 

A (Very Contrived) FI Case Study with A Question

Let's do another one (but this time with a question thrown out to you all). 

This time my sole income is from my dividends (that is, I am financially independent) and I get £15,000 from these dividend payments.

Under the new rules, from April 2016 £11,000 of income (not dividend income, just income) is tax free.

However, this is where I come unstuck. Does this mean:

(1) Because my sole income is from dividends does that mean that the effective tax-free dividend income is £11,000 (that is, the tax-free income allowance) rather than the standard dividend income tax-free allowance? 

If so, then only £4,000 of my dividend income would be taxable at the 7.5% rate. This would result in £300 going to the taxman leaving my net income at £14,700. An effective tax rate of 2%.

(2) Alternatively, it may be that the dividend income is treated separately from general income. If so, I would see £10,000 of my dividend income liable for the 7.5% tax rate. This would leave £750 going to the taxman and my net income sitting at £14,250. An effective tax rate of 5%.

Has anyone fathomed which one is the case yet? I have not, but maybe it will not come clear until later!

EDIT: Thanks to M over at There's Value it has been cleared up that as dividend income is counted as "unearned income" (which has always sounded perilously close to an oxymoron to me) it does not seem to count in your tax-free personal allowance leaving option 2 as--it seems--the ultimate scenario.

I say, ISA...How Attractive You Are

At the moment, I remain blissfully unaffected by these changes. I am actually a basic rate taxpayer and my dividend income--both in my ISA and outside it--remains well below the £5,000 threshold. 

Thinking to the future, happily at the moment 90% of my investments are in an ISA and so most of my dividend income would be completely tax-free anyway. Eventually I hope this to read 100% with these current changes making this move even more attractive than it was.

Anyway, now you can get back to the much more interesting Rolls-Royce analysis post (at least, I think it is more interesting).

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[Creative Commons image reproduced from Flickr user HM Treasury]